Which 529 plan is best for you?

Measuring performance difficult, flexibility key

By

JustinWiser and Kristen Gerencher

Third in a three-part series

WASHINGTON (CBS.MW) - So you've decided to invest in a Section 529 college-savings plan. Now comes the hard part.

"529s" offer major new tax incentives this year to sock away money for a kid's education. See Part I: The New 529 Plans. But determining which of the 42 state-sponsored plans is your best option is a difficult task.

These plans make tough studies because the returns of their underlying funds aren't easily comparable. Most have limited investment choices and short track records that make gauging which may be better long-term performers virtually impossible.

"Every state program has a different portfolio with different options, so it's very hard to standardize" the results, said Joseph Hurley, author of "The Best Way to Save for College: A Complete Guide to 529 Plans" and founder of SavingforCollege.com, which tracks some performance data. See Part II: Using the Web to research 529s.

Investors must weigh state-tax implications, fees and investment options along with performance when deciding which 529 is best. They aren't required to choose the savings program in their home state, nor is the child required to attend a school in that state, so those who find themselves stuck in lagging plans can transfer assets to another state once a year, an allowance granted by last year's federal tax reforms.

On the plus side, the states are adding more investment options as a new tug of war unfolds. The investment companies that administer each state's plans are pushing for more flexibility to compete for national business, and many states are loosening their restrictions and offering lucrative state tax breaks to residents who choose home-state plans.

Performance comparisons

To be sure, finding an apples-to-apples return comparison among the 42 states, some of which offer multiple 529 programs, is challenging.

Contributors shouldn't be dissuaded by plans with funds that posted the biggest losses last year. They likely were aggressive stock funds that fared poorly in the bear market, but which may be exactly the type of funds you'd want to load up on if your child is less than 10 years of age.

For instance, New York's "Aggressive Managed Allocation" fell 21.5 percent last year. Neighboring New Jersey's offerings rose 0.1 percent to 3.7 percent, which preserved assets, but which may be far too conservative for investors with an 18-year time horizon.

Morningstar plans to start offering daily performance data for 529 plans as it does for mutual funds but hasn't settled on an evaluation method yet, fund analyst Dan McNeela said. Plan administrators also are becoming aware of the problems investors face when researching 529 plans, he said.

"As they develop, they'll become more sophisticated in what services they offer investors and chief among them I would think is better reporting of performance data," McNeela said.

To that end, American Funds, which administers one of Virginia's three 529 programs, launched 21 individual mutual funds last month that investors can track as they do any other retail fund. There are no transfer fees for investors who want to switch funds once a year, making it possible to customize accounts, spokesman Chuck Freadhoff said.

"If you have a newborn, you could start off in a growth fund 100 percent and by the time the child is five say 'I want to go to 25 percent in growth and equity,'" Freadhoff said.

Tax considerations

It's wise for investors to check their own state's plan first for any special state tax perks, financial planners said. Colorado, for instance, has no limit on the amount of contributions that can be deducted from state income taxes. Other states allow state income-tax deductions of $1,000 to $10,000.

Additionally, while withdrawals are no longer subject to federal income tax as of this year, some states may still tax withdrawals, which could also impact which plan you choose.

"If you can claim significant state income tax deductions through contributions to your own state's plan, you may want to look no further," said Chris Hunter, program manager for the National Association of State Treasurers, which maintains the College Savings Plans Networks' State Tax Treatment page.

Considering fees

Just as with mutual funds, administrative expenses and sales "loads" can cut deeply into investment returns.

Most states charge annual expense ratios similar to mutual funds, generally less than 1.5 percent of total assets. But Arizona's plan charges up to a staggering 10.97 percent; Wyoming charges up to 2.72 percent; Nevada, 1.92 percent and Maine's fees average 1.8 percent.

The fees can be a humungous drain on returns considering just how much states allow participants to contribute - from $101,6500 in Utah to $268,000 in North Dakota.

Arizona, Ohio and Virginia, meanwhile, allow "front-end" loads on investments made through brokers of up to 5.75 percent - meaning only $94.25 is invested for every $100 contributed, and others charge front-end loads of 3.25 to 5 percent. Those same states and others charge "back-end" loads on withdrawals of up to 5 percent, and they may also charge annual loads of 0.25 to 0.95 percent.

Participants in many cases can escape those loads by investing directly through the state programs and not using brokers and financial planners to act as middlemen.

"The same people that offer low-cost mutual funds are the same people that offer low-cost 529 plans," McNeela said. For example, the state of Utah, which uses low-cost Vanguard funds, also runs one of the least expensive 529 plans.

Aiming for flexibility

Contributors should consider the flexibility in investment options. Many states only offer three or fewer investment options compared with thousands of choices available in the larger fund industry.

Rhode Island this week said it was adding nine Alliance Capital mutual funds to its 529 plan, bringing its total number of investment options to 24.

Other states winning points for flexibility include Ohio, which offers 14 investment options managed by Putnam; Maine, which has 11 run by Merrill Lynch
MER, +1.71%
; and Alaska, with 12 managed by T. Rowe Price
TROW, -2.56%

Of the fund families offering 529 plans, TIAA-CREF has among the lowest expenses but the fewest investment options, while the reverse is true for Alliance funds, said Charles Failla, a certified financial planner with Raymond James.

Among the most restrictive 529 plans are Connecticut's, which has only two non-age-based funds; and New Jersey's, with just five total options. Neither state allows investors to put more than 80 percent of assets in stock, even in their most aggressive choices.

Tennessee's plan consists of only one age-based option, and Kentucky's adds just one other choice to the lifestyle-fund mix.

For individuals who aren't interested in tracking investments too closely and would prefer not to worry about the plan, an age-based investment option may be a good fit, McNeela said.

Kiplinger.com in September cited four state plans that it considers the best in the nation. Bear in mind you should consider the state-tax issue before rushing headlong into these plans:

Kansas Learning Quest Education Savings Program. Kiplinger found this plan's aggressive age-based portfolio attractive -- investing in stocks for youngsters and then moving into lower-risk investments in their teens. It is more than 90 percent invested in American Century stock funds until the child turns 12, and only moves into mostly bonds and money markets at age 17 (Keep in mind there are four years or more until graduation). Management expenses range from 0.91 percent to 1.35 percent.

College Savings Plan of Nebraska. Its ten investment choices are "bountiful," Kiplinger said, and use funds from Fidelity, T. Rowe Price and Vanguard, including an S&P 500 index fund. It preferred the plan's most aggressive option, for which expenses run about 1 percent.

New York's College Savings Program. This plan, managed by TIAA-CREF, offers an aggressive option that also allows putting some contributions into a separate, high-equity and charges low expenses of 0.65 percent of assets.

Utah Educational Savings Plan Trust. Kiplinger liked this plan for its "simplicity" and extremely low expenses. It features just two Vanguard index funds (one stock, one bond) to build its age-based portfolios. Expenses are a "superlow" 0.35 percent.

Questions to ask

Contributors should remember that 529 plans are in their infancy, and states are continuously tinkering with programs and adding new options.

When it comes to choosing the right 529 plan, Brian Orol, a certified financial planner in Raleigh, N. C., recommends his clients ask the following questions:

Are there state tax advantages going into or out of the plan? Twenty-three states now make some part of the contributions deductible on state income tax. Such incentives can make a huge difference in lowering the overall cost of a plan, especially for those that offer tax deductions up front, Orol said. California offers a break on the front end while North Carolina saves the tax advantage for the way out, he said. "A tax break going in tends to work out better given the savings today and the time value of money."

Are there at least five investment choices in the plan? Orol recommends choosing a plan that reflects a traditional asset allocation model, with at least one fixed allocation option, one with bonds, large-cap stocks, international equities and a small or mid-cap allocation.

Do you have a choice of multiple mutual fund families? Alaska's Manulife plan, for example, offers five different fund families, Orol said.

What are the costs associated with the plan? As with most funds, it's important to weigh the expense ratios. Some funds also have annual fees, and those purchased through brokers rather than through the state often cost twice as much. Management and maintenance fees may apply, and nonresidents are sometimes assessed fees that are waived for in-state shareholders. While it's now possible to switch plans, some administrators charge change fees. For instance, Ohio's Putnam plan charges $50 to transfer, Orol said.

What's the plan's annual contribution limit? Wealthier investors may prefer states with higher caps such as Rhode Island's $250,000 ceiling.

Is a 529 plan available through your employer? As a voluntary benefit, 529 plans give employers the chance to offer a popular perk without the expense of company matching, Orol said.

Intraday Data provided by SIX Financial Information and subject to terms of use.
Historical and current end-of-day data provided by SIX Financial Information. Intraday data
delayed per exchange requirements. S&P/Dow Jones Indices (SM) from Dow Jones & Company, Inc.
All quotes are in local exchange time. Real time last sale data provided by NASDAQ. More
information on NASDAQ traded symbols and their current financial status. Intraday
data delayed 15 minutes for Nasdaq, and 20 minutes for other exchanges. S&P/Dow Jones Indices (SM)
from Dow Jones & Company, Inc. SEHK intraday data is provided by SIX Financial Information and is
at least 60-minutes delayed. All quotes are in local exchange time.